Download A Moderate Compromise-Chapter 2 - The International Economics

A Moderate Compromise: Economic Policy Choice in an Era of Globalization
(Excerpt) - by Steve Suranovic (Palgrave McMillan, 2010)
Chapter 2: Why Economic Theory Can’t Tell us What to Do about Policy
Much of what theory can teach us about the appropriate role for government
policy can be gleaned by understanding what theory teaches about international trade.
This is because international trade theory has largely used what are known as general
equilibrium models to understand the effects of trade and domestic policies. General
equilibrium models offer a comprehensive view of an economy because they account
simultaneously for impacts in the output markets, labor markets and capital markets.
Any policy affecting one market is shown to affect every other market both domestically
and internationally. Although the focus of trade theory is primarily on trade of course,
the general conclusions that derive from studying these models have a much broader
applicability.
For many reasons, what to do about trade policy and policies concerning
globalization are highly contentious.
Many economists support a free trade policy
because economic theory suggests that free trade can raise economic efficiency, raise
average incomes, and can generate greater economic growth. Economists often say that
countries will benefit from free trade, thereby positing that an improvement in national
benefits, or national welfare, is a criterion for policy choice. This criterion is an
application of the traditional philosophical principles of utilitarianism outlined by Jeremy
Bentham and John Stuart Mill almost two centuries ago.i Economic theory and models
implicitly accept this principle whenever they address the welfare effects of policies.
We might ask though, what do people mean when they say that a “country”
benefits from trade? Afterall, countries can’t feel a thing?! To economists it means
something very precise; a country benefits when the total real income gains to some
people exceed the income losses to others; it means there is a Pareto improvement; it
means that the net benefits, however measured, are positive; it means that average
standard of living rises.ii What it doesn’t mean is that every person in the country will
benefit from free trade. This is an important point worth emphasizing because it is one
of the reasons many people oppose free trade and globalization.
Rodrik (1997; p.3) points out that, “economists’ standard approach to
globalization is to emphasize the benefits of the free flow of goods, capital and ideas and
to overlook the social tensions that may result.” Indeed, although advocates of free trade
will often acknowledge small, temporary adjustment costs, or even some social tensions,
they will usually be quick to turn attention to the long-term benefits. The implications of
these arguments seem to be that even if someone suffers a welfare loss, it will be
temporary and will be made up with eventual gains in income to compensate. Thus, it is
sometimes argued, if we allow enough time to pass, everyone will indeed benefit from
trade. Unfortunately for free trade advocates though, whereas benefits from free trade
will certainly occur for some people, perhaps even many people, economic theory is also
very clear that some individuals will suffer income losses from free trade even in the long
term. In other words, there is no assurance from theory that free trade is good for
everyone, even eventually.
Economists who support free trade recognize these income redistribution effects.
The economic solution to the redistribution “problem” is a proposal to provide
compensation. Compensation is a transfer of income from those who gain to those who
lose. If done right, compensation can assure that everyone in the country will realize
benefits from free trade. However, for compensation to work, the sum of the gains in the
overall economy must exceed the sum of the losses. In other words, compensation can
only be completely effective if there is an overall increase in economic efficiency.
So, the next reasonable question to ask is whether economic models and theories
demonstrate that free trade will lead to increased economic efficiency, or in other words,
to net national economic welfare gains. Unfortunately, here the answer is no!
models do suggest this, but many others don’t.
Some
The ones that do show efficiency
improvements tend to be the ones that are simpler in structure; those that don’t show
improvements are the ones that incorporate greater real world complexities.
The notion that free trade may not be best for countries, may be surprising to
some, but in fact is a standard result from international trade theory; one that has been
known for a very long time. Indeed, Paul Samuelson, one of the founders of modern
economics, described the notion that free trade is always good for countries as “a popular
polemic untruth.” He argued that, “it is dead wrong about the necessary surplus of
winnings over losings (when countries move to free trade).”iii
The real world complexities that make free trade less likely to be beneficial
overall are known as market imperfections and market distortions. These terms capture a
wide variety of problems including pollution, unemployment, market externalities,
information asymmetries, oligopoly markets, cultural influences, and many others things.
In fact, it is these “problems” that many critics of trade liberalization claim economists do
not take adequately into account.
The critics are both right and wrong. They are wrong because economics has
incorporated many of these problems into their analyses and have derived some very
general, and somewhat unsettling results. The critics are right though too, because it
turns out that their criticisms highlighting the problems of free trade are often valid. In
particular, it has become straightforward to show that free trade may not raise the
nation’s welfare in the presence of most types of market imperfections.iv
The purpose of this chapter is to explain the effects of trade liberalization by
describing the results from a range of economic models and theories. The conclusions
drawn at the end of the review are only those that are virtually indisputable, meaning any
objective observer should accept these results as valid. But widespread acceptance can
only be achieved because the results are very weak; in other words, what can be said with
near certainty isn’t very much. Nonetheless, the lessons that result, apply not only to the
debate over trade policy, but also to the issue of policy choice more generally; the
definitive statements that can be made about trade policy are the same statements that can
be made about any policy decision.
Redistributive Effects of Trade Liberalization
Income redistribution effects arise in a variety of trade models. That redistribution
occurs may not be too surprising, but the complexity of the redistribution is best
understood by considering how and why it arises in different economic models.
In general, income redistribution occurs whenever prices change. Prices are the
signals that other agents use to make their own decisions. When prices change it affects
consumer demand, producer supply, intermediate input demand, wages, rents and many
other things. It is the change in prices that causes some to win and some to lose.
In the simplest trade model we imagine there is only one product being exported
from one country to another. For example, imagine that a trade liberalization agreement
results in a reduction in the tariff on an imported product, say, shrimp. A tariff reduction
reduces the price of shrimp in the importing country. Consumers of shrimp, including the
food-processing companies who make shrimp-based products, restaurants who purchase
shrimp, and final consumers who purchase raw shrimp for cooking in their own homes,
all will pay less for shrimp and thus benefit from the lower prices. Domestic shrimp
fisherman, facing a declining price of imported shrimp, will be forced by greater import
competition to reduce their own prices or face a decrease in demand. Regardless of how
they respond, domestic shrimp producers will suffer losses. The third effect of a tariff
reduction is a decline in tariff revenue collected by the federal government.v Less
revenue will either require an increase in taxes to offset the decline or a decrease in
spending resulting in the loss of some government services. Of course, the government
could borrow more to make up for the shortfall but this would just mean pushing the
effects off until later. In any case taxpayers or government spending beneficiaries either
now or later will lose out.
When tariffs are reduced by large importers it will also cause an increase in the
world price of shrimp.vi Foreign consumers of shrimp will pay more for shrimp at the
market, in restaurants and for other shrimp products and will lose out somewhat. Foreign
producers of shrimp will benefit expand production and see profits rise.
Thus even the simplest model of trade presents a fairly complex redistribution in
welfare around the world as a result of trade liberalization. Trade liberalization will
cause income to be redistributed between at least five distinct groups in both the
importing and exporting country. Consumers of the products whose tariffs are reduced
will gain in real income in the importing country, but consumers of those same products
in the exporting countries will lose income. Owners of firms producing the liberalized
products will lose real income in the importing country but will gain real income in the
exporting countries. Finally, since government tariff revenues will most likely fall,
recipients of government program benefit, or taxpayers, will lose real income.
Redistribution in More Complex Trade Models
The Heckscher-Ohlin-Samuelson, or Factor-Proportions, model assumes there are
two countries (say, the US and Mexico) producing two distinct goods (say, clothing and
autos) using two factors of production (say, labor and capital). The model assumes
workers can work in either industry and will seek the highest wage. Since the model
presumes a capitalist economy, someone is assumed to own the capital equipment and
machinery, which earns that person a rent. Workers and capital owners use their income
to purchase the food and clothing the two industries produce on the basis of their own
desires. Firms decide how much food and clothing to produce, the prices to charge, and
the wage rates and rental rates so that total supply of each good and factor equals total
demand.vii
The key assumptions of the model are two real world regularities; first, some
industries use more capital per worker in production than other industries; and second,
that some countries have more capital available for use in production per worker than
other countries. For example, if autos production use more capital per worker than
clothing production, then auto production is called capital intensive and clothing
production labor intensive. Also, if the US has more capital per worker overall than
Mexico, the US is called capital abundant and Mexico labor abundant. One key result of
this model is that in free trade the capital abundant country exports the capital intensive
good while the labor abundant country exports the labor intensive good.
A very interesting result arises with respect to income distribution in this model.
When two countries, like the US and Mexico above, open up to free trade, first prices
change, and as a result, the real income of the country’s abundant factor increases while
the income of its scarce factor falls. In other words, free trade generates an increase in
the income of capital owners in the US and a decrease in the income of workers. In
Mexico the reverse occurs; workers incomes rise while capital owners incomes fall.
Trade creates winners and losers, but this time the effect is based on the source of one’s
income. If someone earns wage income in the US, no matter in which industry he works,
he will lose from free trade. If someone earns wage income in Mexico, he will lose from
free trade. The reverse is true for capital owners in each country.
In another variation of this model (known as the specific factors model),
economists have considered what would happen if an input factor cannot move between
industries. This assumption is relevant because in many instances workers develop skills
that are specific to the industry in which they work. For example, clothing workers know
how to sew but cannot operate robotic auto assemblers. If the clothing industry lays off
workers and the auto industry is hiring, these workers might not be employable in the
expanding auto industry.
Similarly, capital equipment is typically designed for one
specific purpose. The robotic assembly equipment in the auto industry cannot be used
effectively in the clothing industry. Impediments to factor mobility are real concerns for
workers and capital owners threatened by import competition.
These models demonstrate that when trade is liberalized and a factor is specific to
an industry, those factors stuck in the export industries, benefit, while the factors stuck, or
specific, to the import-competing industries lose. Once again, there are winners and
losers, however, the reason why individuals gain or lose changes based on the structure of
the model.
Finally, economists recognize that the ability of factors to move across industries
improves as time passes. For example, given sufficient time, a worker can learn new
skills and find a job in a completely different industry; the seamstress can learn auto
assembly skills. Also given enough time, capital equipment eventually depreciates and
new investment can be used to purchase newer types of equipment, possibly in a
completely different industry. However, because the mobility of a factor changes over
time, who gains and loses will also vary with time.
Economic models suggest then that in the short run, before labor and capital can
adjust easily to other industries, trade liberalization will harm all income earners in the
import industries, and benefit all income earners in the export industry. Eventually
though, after factors adjust to new sectors in the long run, the country’s abundant factor
will gain while its relatively scarce factor will lose.
This result implies that some
individuals will gain in the short run and lose in the long run. Other will lose in the short
run and gain in the long run.
General Implications
Economists have developed even more complex models of international trade
including some with multiple goods, multiple factors and multiple countries. However,
regardless of the complexity of the model and regardless of which features are included
or excluded, there is one basic result that (almost)viii all models of international trade
display: trade liberalization causes income redistribution. This occurs because free trade
causes the prices of many goods and services to change; some people benefit while others
lose from free trade.
Because income redistribution occurs whenever prices change, this same
conclusion applies whether trade is liberalized or protected. It doesn’t matter what new
set of policies is put into place, any policy change, whatsoever, will cause prices to
change and will also result in winners and losers.
Thus, if countries lower export
subsidies, or implement a carbon tax, or set new health and safety standards, or reduce
the income tax, prices of some goods or services will change and this will cause a
redistribution of income with some people benefiting and others losing.
In fact, even if there are no policy changes at all, other natural changes like the
depletion of resource stocks, technological changes, changes in consumer preferences and
changes in fiscal and monetary policies all cause prices to change. This means that even
when a country does almost nothing, there will be continual redistributions of income.
The income redistribution result is shown in simple trade models and becomes
even more prominent in more complex models.
There should be little doubt that this
same result carries over to the real world.
As mentioned earlier, the solution to redistribution is to provide compensation to
the unlucky losers caused by the policy change, paid for out of the extra earnings
accruing to the winners. However, to make redistribution completely effective so that no
one loses, the net benefits from the policy change must be positive. Or in other words the
policy must cause an increase in national welfare. We explore this issue with respect to
globalization policy in the next section.
National Welfare Effects of Trade Liberalization
Despite the redistribution, most advocates of free trade and globalization believe
that, overall, trade liberalization will be good for countries. That belief derives from a
substantial literature showing that trade can raise economic efficiency. Economists use
the term “efficiency” to describe an optimal allocation of resources in production and
consumption. More specifically, “Pareto efficiency” refers to an economic outcome in
which it is impossible to raise the well being of one person without simultaneously
reducing the welfare of someone else. If it were possible to make one or several people
better off without harming anyone else, then that situation is NOT efficient.
Comparative Advantage and Efficiency Improvements with Free Trade
In general, economic efficiency improves with free trade when countries
specialize, or produce more, of the goods and services in which they have a comparative
advantage. A comparative advantage, when defined in its most general form, arises when
a country enjoys a price advantage (i.e., a lower price) in a particular good or service
compared to another country. Different economic models show that a price advantage can
arise because of cross-country differences in technology, because countries have different
proportions of capital and labor, or because of differences in product demands.
Comparative Advantage via Differences in Technology
In the Ricardian model, countries are assumed to differ only in their productive
capacities.
It was in this model that David Ricardo first formally demonstrated the
principle of comparative advantage. An important conclusion from the Ricardian model
is that advantages from trade do not disappear just because another country has lower
wages, nor do they disappear just because another country is more productive in all
industries. Ricardo demonstrated that by specializing in producing the products that one
has a comparative advantage, the world can expand total world output with the same
quantity of resources. The expansion of output is the realization of increased economic
efficiency that economists always talk about. Finally, given the expanded output,
international trade can assure that all countries in the model gain from the surplus that’s
created. In other words, without raising the quantity of resources, the world economy
would be able to produce greater output and generate higher living standards for
everyone. Economic efficiency will rise both internationally and nationally. This is how
all nations can benefit from free trade.
Comparative Advantage via Differences in Resources
The Heckscher-Ohlin-Samuelson, also known as the Factor Proportions model,
assumes differences in resources between countries and comparative advantage is
determined by differences in factor proportions. The capital abundant country has a
comparative advantage in the capital-intensive good and the labor abundant country has it
in the labor-intensive good.
In the model, world production is maximized when the capital-abundant country
produces relatively more of the capital-intensive good and exports it, while the labor
abundant country produces more of the labor-intensive good and exports that. Although
as discussed earlier, a movement to free trade redistributes income from the countries’
scarce factors to its abundant factors, the net national welfare effect is positive. In other
words, the sum of the benefits to the abundant factor is larger than the sum of the losses
to the scarce factor. Thus, the model displays an improvement in overall economic
efficiency with free trade, and with appropriate compensation provided, all people in all
countries could conceivably be made better off.
Advantages via Economies of Scale
More recent models of trade focus attention on economies of scale. Economies of
scale, also called increasing returns to scale, occur when a larger production volume
enables cheaper production. For example, in heavy industries, such as chemical or steel
production, the cost of producing each unit of output falls substantially if large volumes
are produced at one place and time. Clearly in these cases it makes sense to produce at a
very large scale so as to reduce the production costs per unit.
At the international level, the presence of economies of scale in production has
been identified as a potential source of benefits from free trade. In this case, we would
not say that trade is based on comparative advantage because it does not rely on
differences between countries.
As an example, suppose two countries produce two goods, steel and chemicals,
which exhibit economies of scale.
One possible production arrangement is for both
countries to close themselves off from trade and produce the two goods for themselves.
In contrast, if one country were to specialize in steel production and the other in chemical
production, and if each industry supplied its product to the entire world, rather than just
one country, then the scale of production would be higher in these industries and the cost
of producing each good lower (due to economies of scale). Thus, once again, because of
international trade economic efficiency can be improved and the overall welfare of both
nations increased.
Efficiency and the Division of Labor
In all cases efficiency improvements derive from one fundamental principle; the
division of labor. From at least the time of Plato people have recognized that when
individuals concentrate their productive effort along one production task, it becomes
possible to significantly increase output. Adam Smith began his famous treatise, The
Wealth of Nations with a detailed explanation of the division of labor.ix Using an
example of a pin factory, he explained how specialization in particular tasks within a
production process would enable each person to become more efficient in that task, and
when combined with others performing other tasks, would result in a substantial increase
in the output of pins.
It is worth recognizing that the economic efficiency improvements from
international trade, as depicted in all models of trade, are demonstrating that additional
gains can be realized by extending the division of labor internationally. If individuals can
reap benefits domestically through specialization and trade, then countries can extend
these gains to its fullest potential via international specialization in one’s comparative
advantage goods followed by trade. To deny that international trade can be beneficial is
to deny that the division of labor extends internationally. This seems highly unlikely.
However, what one could argue is that other complications in the world may cause
additional inefficiencies that overwhelm the positive effects caused by extending the
division of labor. For this reason we take up the issue of market imperfections next.
Market Imperfections and Distortions
In all of the basic trade models, certain real world complications, known as
market imperfections or market distortions, are assumed away. When these imperfections
are incorporated into the models, the traditional result that countries will gain from trade
due to improvements in economic efficiency is undermined.
The term market imperfection is used to describe these situations because each
represents a deviation away from the standard assumptions of perfect competition, upon
which many economic models are based.
Perfectly competitive models include
numerous assumptions. Some of them are made because it is believed they describe an
important aspect of the world. However, many other assumptions are made to simplify
the analysis. In many ways, the world described by the model of perfect competition is
indeed perfect. It’s a kind of “economic nirvana;” an idealistic outcome that we should
never expect to arise naturally in the world, nor should we ever expect to attain it –
except perhaps in a future life!x
When economists build models of the world that incorporate imperfect
competition they often describe these cases as second-best. When things are imperfect,
we are in a second-best world. On the other hand, the state of economic nirvana that
arises in perfect competition is often referred to as first-best.
Next I’ll describe several models with market imperfections and discuss the
implications for free trade for each of these. Afterwards, we’ll consider the implications
for a world that is awash in imperfections, as we may well expect to see in the real world.
As economists often cryptically proclaim, we live in a second-best world.
International Trade by Large Countries
The first hint students of international economics get that free trade is not always
best for a country happens when they learn about optimal tariffs in a large country case.
Countries are classified as large or small on the basis of whether their trade policies can
influence the price of a product in international markets. Thus, when a “large” country
places a tariff on an imported good, the price of that product in the rest of the world is
pushed downward because of lower international demand. In contrast, a small country’s
import tariff would have no effect upon the price in the world market. Largeness also
applies on the export side. If a large country introduces an export subsidy on a product,
the price of the product in the world market is pushed down, this time because of
increased international supply. A small country’s export subsidy, however, has no effect
upon the world price.
What students learn in an international trade class is that a relatively small tariff
implemented by a large importing country raises national welfare; in other words
economic efficiency improves with protection.
The same positive effect on welfare is
possible on the export side when a large country implements an export tax. In contrast, if
any tariff or export tax is implemented by a small country, national welfare falls.
To see that it is not just a theoretical curiosity, one need only look to the welfare
benefits achieved by OPEC countries during the oil embargo era of the 1970s. When oil
supplies to the world market were temporarily curtailed, the world price of oil rose
threefold and revenues streamed into OPEC government coffers. This is the same effect
as described in models of a large country implementing an export tax. An export tax, or
an export quantity restraint, by a large country raises world prices and result in a flood of
revenues to the government. The effect was even more profound for oil because oil
demand is very inelastic in the short runxi due to a lack of cheap substitutes. From this, it
is not hard to imagine that welfare improving import tariffs are also a very real
phenomenon.
The reason free trade is not optimal in the large country case is because there is an
apparent market imperfection. An imperfection exists here because a nation’s ability to
influence the world price gives it the same kind of ability as monopoly firms in a
domestic market who are able to affect the market price.
capabilities are assumed away in perfect competition.
These price-influencing
To get a truly perfectly
competitive setting in international trade requires each country in the world to be too
small to be able to influence world prices. This is what we assume in the small country
scenario. However, when a country is large, it can use its international market power to
influence the price to its advantage.
Surely the US, EU, Japan and many other countries with large economies are also
large importers and exporters of many products in international markets. Thus, this is a
real feature of the world economy, not just a theoretical curiosity. The implication is that
when countries have the “largeness imperfection,” trade liberalization can actually lower
national welfare. Or, in other words, in this setting free trade is not best.
Externalities
One very important type of market imperfection is known as an externality. An
externality exists whenever activity in one market has an external effect on firms or
individuals in another market, in a way that is not captured by (i.e., external to) the
original market itself. Externalities arise in production processes as when chemical
production causes air and water pollution, or when research and development activities
spillover to create innovations in other industries. Externalities also arise in consumption
as when driving a private auto causes local air pollution or when cigarette consumption
has social health costs. Externalities can be either positive or negative in their effects.
Pollution causes negative externality effects, whereas landscaping of a corporate
headquarters has a positive externality effect.
Infant Industry
A classic argument in support of protection is the infant industry argument. This
argument goes back to the time of Adam Smith and before. It is commonly invoked
today by less developed countries to support their significantly higher trade barriers.xii It
is also another case in which market imperfections in the form of an externality plays a
role.
The argument suggests that new industries (infants) in underdeveloped countries
are unable to compete head-to-head with firms in more developed countries since they
lack the experience and knowledge necessary to reduce production costs. However, if
these infant industries are given temporary protection, say in the form of import tariffs,
then this will provide time for these firms to learn the skills and knowledge to reduce
costs. Eventually, after adequate nurturing while young, these same firms will grow up
and be able to compete as equals with the mature firms in the international market.
The market imperfection in the infant industry case is a positive production
externality. Thru production of a product, the firms in the infant industry are expected to
learn how to reduce production costs and become more efficient over time. Economists
refer to this as “learning by doing,” The external effects of learning are experienced only
later in time, perhaps many years after the initial protection is first provided.
If capital markets worked perfectly, then infant industries could easily borrow
money in the early years to overcome early production losses, which would then be
recovered after the long-term efficiency effects are realized. However, since capital
markets rarely work this effectively, the external effects are incompletely captured by the
market mechanism.
The market may also not capture the learning effects if they spillover into other
industries.
For example, if part of the learning process involves new cost-reducing
management techniques and if the managers who implement these measures eventually
take jobs in other industries, then these other industries may also achieve similar costsavings. Since these efficiency effects occur external to the industries that first created
them, they cannot be captured by the market mechanism.
For these reasons, non-intervention in the presence of infant industries is a
second-best outcome. It also means if the long-term benefits of production outweigh the
early costs of protection, which indeed they might, then protection can improve overall
welfare for a country. In contrast, if a country with potential infant industries reduce, or
eliminate, trade barriers, then free trade could reduce long-term economic efficiency of a
country in this situation. In other words, trade liberalization, or free trade, may reduce
the national welfare in the presence of this type of market imperfection.
Pollution
A classic example of a negative externality is pollution. Water, air, soil and
aquifer pollution is caused in numerous production processes whenever active
intervention to control that pollution is not undertaken. Examples include air pollution
caused by traditional smokestack industries like steel, chemicals and power generation;
water and soil pollution caused by fertilizer and pesticide use in agriculture; and water
and aquifer pollution caused by extractive mining industries. Pollution is also caused in
some consumption activities; most notably the air pollution caused by household use of
automobiles and water pollution in locations without sewage treatment facilities.
Pollution can have serious detrimental effects upon others. Industrial plants have
sometimes dumped chemical waste into the ocean causing serious declines in the
production of the nearby fishing industry as well as health problems among consumers of
seafood. Air pollution causes breathing problems especially for people with respiratory
ailments. Water pollution can damage the recreation and fishing industries downstream.
Finally, aquifer pollution can affect the safety of public water sources and lead to serious
long-term health consequences among consumers.
Economic theory shows that in the presence of production externalities, firms
tend to over- or under-produce relative to what’s best for society overall.
When
consumption externalities are present, consumers over- or under-consume relative to
what’s best. Theory also shows that government intervention with appropriately chosen
policies can correct the over or under production and consumption and result in an
improvement in the nation’s welfare. International trade theory has shown, in turn, that
when these externalities arise among traded goods and services, trade policies can often
be applied to improve the nation’s welfare.
For example, consider a country that imports crude oil. The oil is refined into
gasoline and used by consumers to power their automobiles. In the process of both
production and consumption, air pollution is created in the community. The pollution has
negative health effects especially upon those individuals with respiratory ailments. Thus,
the use of crude oil exhibits a negative production externality in the refining process and
a negative consumption externality when gasoline is used in automobiles. If a free
market prevails, refineries will overproduce gasoline, and households will overconsume
gasoline relative to what is best for the nation overall.
Trade theory shows that government intervention in the form of an import tariff
on crude oil would raise the domestic price of gasoline, reduce gasoline refinery activity
and consumption and reduce the amount of pollution. Lower pollution would generate
positive health effects in the community. Thus, a protectionist trade policy, if set at the
appropriate level, will raise national welfare if the positive health effects outweigh the
standard economic efficiency losses of protection. The reverse implication is true too;
free trade, or trade liberalization, may lower national welfare in the presence of this
externality.
Free trade may not be the best policy in the presence of a negative
production and consumption externality.
Cultural Externality Effects
Concerns about free trade and global markets have more recently involved the
issue of culture. Most of the time, economists portray issues like culture as falling
outside the realm of economic analysis. However, culture can be easily introduced as an
externality effect.
For example, many countries are especially fearful that American music, films
and TV programs will push out local offerings and lead to the Americanization of their
culture. For this reason, many countries have laws that require certain minimum levels of
domestic programming for radio and TV broadcasts. Many countries also restrict the
percentage of screenings of foreign films. From an economic theory perspective, this is
another example of a market imperfection in the form of an externality.
These restrictions can be beneficial for a country because the cultural effects of
imported products can be viewed as a negative consumption externality. In this case
maintenance of cultural traditions embodied in music, film and TV programming,
benefits everyone in the community through the promotion of certain cultural
understandings. Since each person’s individual consumption is too small to have a
noticeable effect on the community welfare, there will be a tendency to underconsume
relative to what’s best for society from a cultural perspective.
For these reasons, domestic regulations can raise the level of consumption of
cultural goods, correct for the under-consumption, and if the cultural benefits outweigh
the standard economic efficiency loses due to lower imports, then the national welfare
can be increased with protection.
As before, the reverse is also true; if cultural
restrictions are eliminated as might be agreed to in a trade liberalization measure, the
effect may be a reduction in the nation’s welfare. Trade liberalization can make a
country worse off in the presence of a cultural externality. Thus, it is conceivable that
Europe might reduce its national welfare if it eliminated domestic content requirements
on television and movie screenings.
Public Goods
Perhaps the most common economic argument in support of government
intervention is the need to provide public goods.
Public goods, of which national
defense is the most notable example, have two defining characteristics: non excludability
and non-rivalry. Economists have long known that a free market is likely to undersupply
public goods, mostly because some beneficiaries are likely to free ride on the
contributions of others. To solve this undersupply problem, governments can collect
taxes and use the money to supply an adequate national defense. In this way government
intervention can raise the national welfare of a country.
With the insight of the effects of market imperfections, we can now recognize that
if government intervention can raise national welfare in the presence of public goods then
public goods must represent a type of market imperfection. Indeed, in a pure perfectly
competitive market model, we assume away public goods, imagining they do not exist.
When public goods do exist, the inefficiencies that arise when a free market tries to
provide them can be reduced with appropriate government intervention.
Indeed, from an economics perspective, the primary rationale for most public
policies, is simply the correction of market imperfections and distortions. Regulatory
policy to reduce pollution, taxes on cigarette and alcohol purchases, antitrust
enforcement, unemployment compensation, the provision of a national defense and
income redistribution policies can all be justified by noting that they can correct for
market imperfections and result in an improvement of a nation’s overall welfare.
As
discussed above, in many instances trade policies can be applied in a similar way. When
goods cross borders, trade policies can effectively correct for these same imperfections
and result in an improvement in national welfare.
With perfect competition there are none of these worries or concerns. There are
no public goods, no unemployment, no externalities of any kind. As a result, the very
best domestic government policy is no policy at all. Laissez-faire is the term used to
describe the total avoidance of all government regulatory, tax and subsidy policies.
When laissez faire is applied to international trade, it implies free trade.
Policy Imposed Distortions
But what if an economy were perfectly competitive in all respects, but then some
policy is added, like a tax on cigarettes, or a production subsidy, or an import tariff?
Economic theory shows that for any such policy, national welfare will fall. Government
policies in the form of regulations or taxes and subsidies change prices and thereby
distorts the allocation of resources causing a loss in economic efficiency. Although
previous examples have shown that sometimes efficiency is improved with government
policy, that only occurs when it corrects for the negative effects caused by an
imperfection. In the absence of an imperfection, trade policy is the imperfection … it is a
distortion.
Economists sometimes call government taxes, subsidies and regulations
policy-imposed distortions because the distortion is caused by government action.
Once we recognize that government policy is a distortion in its own right, we can
also realize something else very important; that the correction, or improvement, of one
imperfection is actually achieved by implementing another imperfection or distortion on
top of it. For example, consider the earlier example where a government places an
import tariff on crude oil that in turn reduces the use of gasoline and reduces air pollution
in its cities. In this case the government is placing a policy-imposed distortion or
imperfection (the import tariff) on top of another imperfection (a negative externality).
The tariff has two impacts: it corrects the negative externality, but at the same time it
reduces efficiency. If the economic efficiency cost of the import tariff, is less than the
economic efficiency benefit that results from the reduction in pollution, then the policy
improves the national welfare. That means, somewhat paradoxically, two distortions can
be better than one.
Indeed, there are only two ways to make the economy more efficient and move it
closer to economic nirvana.
The first method is to eliminate the imperfection or
distortion directly. For example, if a country really were a small perfectly competitive
economy with protective tariffs in place and with no other market imperfections present,
then efficiency is best improved by eliminating the tariffs; simply move to free trade.
However, if the imperfections are there naturally, as is the case with most externalities,
then one can’t simply eliminate them. Instead, the only way to improve economic
efficiency is to impose an additional, appropriately chosen, policy-imposed distortion.
I say appropriately chosen because it is necessary that the corrective distortion be
set at the right level. It is easy to show in the pollution case, for example, that if the tariff
were set too high, then the efficiency losses caused by the tariff may overwhelm the
benefits caused by reduced pollution. Thus, the tariff must be set at the proper level to
generate the positive efficiency effects.
Other externality effects
There are many other examples of market imperfections or distortions that we
could explore including the presence of monopolies or oligopolies, the problem of
imperfect information, and the non-clearing of markets, which arises with
unemployment. However, these examples are sufficient to demonstrate the main point:
namely that in the presence of a market imperfection it is possible for a government to
intervene in a calculable way to improve national economic efficiency and raise the
average well-being of its residents. The common method to correct for these problems is
the use of government taxes, transfers and domestic regulations.
Theory of the Second-Best
In studying the effects of various types of market imperfections economists
derived an important complementary theory called the “theory of the second-best.”
Second-best theory was first formulated by Robert Lipsey and Kelvin Lancaster in the
1950s.xiii A key finding of this theory was to show that if a market imperfection were
present, the addition of another distortion could actually improve the outcome for a
country.
Second-best theory also demonstrates another critically important proposition:
namely the presence of one imperfection or distortion in an otherwise perfectly
competitive economy, immediately changes the optimal policy response everywhere else
in the system. This is a very significant result.
For example, consider a small economy importing and exporting many different
products with no imperfections present or distortions in place. In this case we know that
the optimal policy is zero tariffs and zero export taxes or subsidies. In other words, free
trade is optimal in every market. However, suppose the government, contrary to the
policy advice of its economic advisors, imposes a tariff on imports of one good. One
might conclude that this not so bad since the government is choosing free trade for every
other import and export good and perhaps this is true. However, according to the theory
of the second-best, the optimal policy for every other good and service is no longer free
trade. Once a distortion is placed into the system, it will upset the optimality conditions
for every other substitutable good or service in the economy. With one distortion present,
the optimal trade policy for other goods and services may be a small tariff, export tax or
an export subsidy; we can no longer assume that free trade everywhere else is best. This
result has profound implications for our main question: namely whether free trade is
beneficial for a country. It is also one reason why the theory of the second-best is one of
the most important results in all of economics.
What is the Imperfection?
All of the previous examples, and many more, in which government intervention
raises economic efficiency and national or international welfare can always be interpreted
as a correction of a market imperfection through the use of a policy-imposed distortion.
This is one reason why there are very few interesting new welfare findings in
international trade theory. For example in recent years press reports have begun to
suggest that the case for free trade has been weakened by new trade theories. Back in the
1980s, theoretical work on strategic trade policies showed that government subsidy or
taxes could be used to shift profits from foreign firms and raise a nation’s welfare. It
seemed, free trade was no longer the best policy. In 2004 when Paul Samuelson
published an article suggesting that outsourcing could make a country worse off, once
again the popular press declared that the foundations of free trade were weaker than
previously believed.xiv
To trade economists, these results were not surprising or new.
Once you
recognize that trade policy can correct for innumerable market imperfections, any new
model or theory that demonstrates that free trade is not best should inspire only one
question: what is the imperfection in the model?
In the case of a large importing country, the imperfection is monopsony power in
trade. Similarly, in the case of a tariff on crude oil reducing pollution, the imperfection is
a negative externality. In the case of an infant industry, the imperfection is a positive
production externality.
imperfections that exist.
These are just a few examples; there are many more
And for each imperfection, it is highly likely that an
appropriately chosen trade policy can raise national welfare.
Reducing Distortions
It is logically tempting to think that if a distortion causes a reduction in economic
efficiency, then reducing that distortion will improve efficiency. This proposition is true
only when there is just one distortion present.
If there are multiple distortions or
imperfections present simultaneously, then the theory of the second-best shows that the
proposition is no longer generally valid. In a sense we have already seen this result in
reverse. In the previous section we noted that one imperfection could be corrected to an
extent by appropriately implementing another policy distortion. Since adding a distortion
or imperfection can be better than just one, it must mean that subtracting one distortion or
imperfection can be worse than having two. Moving from two distortions to just one can
arise only by reducing or eliminating an existing one. There is a classic example of this
phenomenon in the trade literature.
Free Trade Area Formation
Free trade areas are an excellent example in the trade literature that displays
surprising results because of the presence of multiple distortions.
It has been known for
a long time that when a country enters a free trade area with another and lowers its tariffs
to zero, it is possible for the country to make itself worse off.xv In other words, despite
moving towards free trade, a step that in many circumstances improves economic
efficiency, instead it is possible, though not assured, that economic efficiency declines.
To economists this is the classic case of trade diversion.
This result, namely that an FTA can reduce economic efficiency and make a
country worse off, can be interpreted in the context of the theory of the second best.
When a country establishes an FTA, it is indeed a step in the direction of the economic
nirvana of free trade, however, it is only a partial step. Since the FTA partners continue
to maintain tariffs against other countries, some market distortions remain in place.
When a tariff is removed only against one country, the liberalization can have the
surprising effect of making the remaining distortions more distorting.
Effects with Multiple Imperfections
Trade diversion is the most notable example in which reducing a distortion can
lead to a reduction in a nation’s welfare. However, what’s true in this specific case, is
also true more generally. Whenever there is more than one imperfection or distortion in
an economic system, reduction or elimination of one distortion need not result in an
improvement in economic efficiency and national welfare. It might, …. but it just as
easily might not. The most important implication of this result is what it says about a
movement to free trade.
Trade liberalization represents a reduction in some policy-imposed distortions,
whereas free trade is the elimination of some policy-imposed distortions. If either of
these actions occurs while other market imperfections or distortions are in place, then
there is no guarantee, from theory, that economic efficiency and national welfare will
improve. It may rise, but it just as easily may not. Below we’ll consider what we would
need to know to determine if the effect of trade liberalization is positive or negative in a
real world setting. Before that we consider an alternative justification for free trade that
doesn’t depend on this knowledge.
Real World Implications
Almost all economic analysis of policy options in a model with market
imperfections assumes that there is just one imperfection to be corrected. In those
circumstances, it is fairly straightforward to determine the optimal policy and to compare
the best trade policy with the best domestic policy. However, things become increasingly
complicated if there are numerous imperfections and distortions at work simultaneously.
Surely, this is the situation most reflective of the real world.
In the real world, some industries create positive externalities, others negative
externalities. Some firms have market power and can affect their market price. Some
products are differentiated within an industry.
Some consumption activities cause
positive externality effects; others cause negative effects; others still cause both positive
and negative effects.
Unemployment is more likely to develop in some labor markets
and is less likely in other markets. Products display different degrees of public good
characteristics. Participants in many markets must deal with imperfect and asymmetric
information. Finally, some countries have monopoly and monopsony power in trade.
These imperfections not only exist, but they vary in strength and importance
across industries and across countries. In some countries, labor markets are more flexible
than in others. Some economies have greater problems with environmental externalities
than other countries, partially because of the age of the capital stock and the choice of
fuel. Information problems vary from country to country. Some counties have bona fide
infant industries; others do not. The extent of monopolization varies widely and is
always changing, especially as some countries privatize state-owned enterprises.
In addition, every country implements a complex mix of domestic tax and
regulatory policies, all of which represent market distortions relative to the pure state of
economic nirvana. Each one of these distortions affects supplies and demands and
thereby affects the prices faced by producers and consumers of virtually every good sold
in an economy.
Anytime prices change, it affects the production and consumption
decisions of economic agents, which in turn, interact with the market imperfections that
are present, for better and worse.
These price effects will also ripple through the
economy affecting intermediate goods industries, labor and capital markets and
consumption markets for substitutable goods.
Simply imagine any country and think about all the policies that government has
put into place. There are social security taxes, income and property taxes, profit and sales
taxes.
There are agricultural support programs, subsidy programs for low-income
households, and food stamp programs. There are programs for health insurance and
medical treatment, unemployment compensation schemes. There are health and safety
regulations, anti-competition policies, and environmental regulations. In addition, we
shouldn’t forget about the operations of the country’s legal system and its security
systems including police and fire protection, national guard operations and the national
military defense.
Of course, for each of these domestic policies there is a rationale; the policy was
put into place for a reason. More than likely, the reason will involve the correction of a
market problem; some type of market imperfection. If a country is lucky, the collection
of policies in place will have moved that country closer to its optimum, its highest level
of national welfare. But how would we know if this is the case?
The Theory of the Second-Best and Ethanol Subsidies.
The theory of the second best teaches a very important lesson that’s pertinent
here; every policy-imposed distortion and every market imperfection affects the optimal
policy choice everywhere else in the system. Consider an illustrative example; suppose a
country implements a production subsidy on ethanol. The stated rationale for the subsidy
may be to stimulate cleaner fuel sources, to mitigate concerns about global warming and
to reduce dependence on foreign oil. These rationales represent corrections of market
imperfections; one correcting for a negative environmental externality, another promoting
the public good provision of national security. However, we can speculate about the
effects of this policy to see what ought to be taken into account to choose the correct
subsidy level.
First, the subsidy to ethanol production will increase ethanol supply forcing the
price down relative to gasoline and lead to substitution of ethanol for gasoline by
consumers. This may lower overall carbon emissions and have a long-term positive
influence on the global temperature. The subsidy will also reduce demand for gasoline
and the imports of crude oil from the rest of the world. However, the ethanol subsidy
may also increase the demand for corn, an important input in ethanol production. This
will raise the price of corn and inspire an increase in corn production. Greater corn
production may stimulate greater demand for fertilizer and, because of its use, cause
greater water pollution in some areas. Higher corn prices may also raise the price of beef
and pork thereby encouraging people to substitute more vegetables in their diet. This
may have a positive health effect by lowering average cholesterol levels in the
population. Reduced demand for beef might also lead to unemployment in the beef
industry. For those workers with specialized skills, they may be unemployed for a long
period of time leading to higher unemployment compensation expenditures. Despite
causing mixed effects on food output, if the overall effect of the subsidies were to raise
agricultural production, that could increase the security of the nation in the event of a
major war.
However, greater corn production might be undertaken largely by
conglomerate agribusinesses forcing a more rapid decline of the family farms and a
subsequent loss of a national cultural heritage.
These are just a small set of effects one policy might cause. Not only does a
policy affect the activity it is directed towards, but it also affects every related activity.
Changes in these related activities, in turn affect an even larger set of activities related to
these related activities, ad infinitum. To the extent that the related activities and subactivities influence different sorts of market imperfections or distortions, it will also
change the effectiveness of every other policy that was put into place to correct them.
This means that to assess the appropriateness – that is, the optimality - of any one policy
requires knowledge about the level and effect of every other policy and imperfection that
might be influenced either directly or indirectly.
Stated in terms of policy choice: if you change one policy in a complex
interconnected economy, it will change the optimal level of every other policy in the
system.
The only way to identify the optimal policy mix is to accurately specify the
entire economic system and solve for the best policies. Stated in terms of effects: if you
change one policy in a complex interconnected economy, it will cause positive effects to
occur due to some of the imperfections and distortions and negative effects to occur due
to other imperfections and distortions. The only way to know if a particular policy will
have net positive or negative effects is to accurately specify the entire economic system
with all of its market imperfections and then calculate the effects of the policy change.
Economists generally know about this result, but it is very uncommon for anyone
to emphasize the problem. In part that’s because these results undermine just about every
policy prescription ever made. To advertise these results loudly reduces the reliability of
many of the policy claims by the economics profession. Further, without some viable
alternative what would be the point of advertising this?
Thus instead, recognition of
these effects is more likely to be found only in footnotes or mentioned briefly in a
conclusion of a policy paper.
Lal (2006; p.55) reveals the quiet admission of this
problem by quoting a passage from a paper by B Greenwald and Nobel Laureate Joseph
Stiglitz. Greenwald and Stiglitz write:
“We have considered relatively simple models, in which there is usually a
single distortion… Though the basic qualitative proposition, that markets
are constrained Pareto efficient, would obviously remain in a more general
formulation, the simplicity of the policy prescriptions would disappear.
Does this make our analysis of little policy relevance? The same objection
can, of course, be raised against standard optimal tax theory. (Some
critics might say, so much the worse for both)” [Quoted from Greenwald
and Stiglitz (1986; p. 258)]
The term “constrained Pareto efficient” is the same as saying there are market
imperfections. The rest suggests why critics can argue that such simple analysis doesn’t
say very much about policy choice in the real world. Lal concludes with a pithy remark,
“Quite!”
The real problem with an optimal policy choice that will correct for the vast array
of market imperfections that are scattered uniquely through every economy, is that it is
unsolvable from a theoretical perspective because of the enormous complexity. It is true
that governments do engage in some degree of cost-benefit analysis to decide whether to
introduce new policies. It is also true that more and more issues of potential concern are
being incorporated when conducting these evaluations. For example, in the US many
proposed government projects are required to conduct an environmental impact
assessment before the policy is implemented.
In this way, the potentially negative
externality effects can be incorporated into the decision process. While it is true that this
is a step in the direction of completeness, at the same time, it masks the fact that
numerous other market imperfection impacts are never even considered in these same
studies. Also rarely, would a government decide to adjust the level of all other policies
whenever a new policy is being implemented (as would be necessary if we were truly
optimizing).
The Problem of Chaos
One way to mitigate this problem of optimal policy choice is to argue that even
though every change in the economic system affects everything else in the economy, the
magnitude of the effects will vary in a systematic way. For example, the effects of an
ethanol subsidy will have its largest effect in the ethanol market itself. It will have a
pretty big effect in the corn market since corn is an important input. The effect in the
vegetable and beef markets, being one more industry removed, should be affected to a
somewhat smaller degree.
The effect on health because of changes in cholesterol
consumption or the effect on pollution due to increased fertilizer usage will be even
smaller because these effects will be separated to the third degree. In other words the
effects beyond the initial market are likely to dampen with each degree of separation
from the original policy. Thus, if the effects of all policies follow this systematic pattern
of dampening the farther removed an industry is from the initial distortion, then although
we might need to consider the implications of a policy change across several levels of
effects, we don’t really need to consider them across the entirety of the economy. While
the problem may still be quite complicated, with the “dampening effects” assumption it is
now much less complicated than originally suggested.
The counterargument to this dampening story is chaos theory. Chaos theory has
been popularly represented by the following metaphor: one beat of a butterfly’s wings in
Texas may be sufficient to cause a tornado to form in Florida a week later. I suspect this
example leaves many readers puzzled. Is that really possible, one may wonder? The
answer is, we don’t know; the story is simply an illustration of something that is seen in a
mathematical system.
The mathematics of chaos isn’t really that difficult. Researchers have discovered
that some seemingly simple mathematical relationships display chaotic behavior.
Chaotic behavior occurs whenever a very small change in initial conditions (like the flap
of a butterfly’s wings) can have a dramatically different effect upon the outcome (the
tornado). One example of chaos in a mathematical system shows up in the Mandelbrot
set. The Mandelbrot set plots different colors depending on whether a simple series
converges to a real number or whether the series diverges to infinity (which is a very
different outcome). The discovery of chaos demonstrated that if you moved a parameter
input in the series by a very small amount (from something like 5.00001 to 5.00002) the
value of the summation, the outcome, can change enormously.
A globalization example of chaos might be something like ethanol subsidies.
Suppose an ethanol subsidy, by encouraging a series of impacts that propagates through
the global economy over time, saves the world from the disastrous effects of global
warming. The oceans don’t rise 50 meters, hurricanes don’t grow to magnitude 15 and
the summer temperature on the north pole does not rise to 40°C. Suppose without the
subsidy the world does experience these terrible effects. In this case, avoiding a small
change in policy (the subsidy) pushes the human race to extinction (chaotic effect). Of
course, this is a fanciful, make-believe example. I wouldn’t expect an ethanol subsidy to
matter very much in the long run; but then, that’s because I don’t know whether a chaotic
effect exists in this situation or not.
It’s true that chaos theory doesn’t prove anything about the way the world works.
Instead, chaos theory should simply raise suspicions of seemingly reasonable
assumptions: such as the expectation that the effects of policy changes in an economy
will have a dampening effect as the degree of separation from the policy increases. If
chaos is present in some real world situations, it would mean that small changes in policy
affecting one market could have very large impacts somewhere else. Once again we can
never know what the effects of a policy change will be unless we can accurately specify
the entire economic system with all of its market imperfections and calculate the effects
of the policy change.
Conclusion
In a nutshell, the definitive lessons about trade policy that we learn from
economic theory are: A) trade liberalization will cause a complex redistribution of
income with some individuals realizing welfare improvements but others realizing
welfare losses; B) due to the complexity of the real world, it will be difficult to identify
all but the most immediate effects of trade liberalization; C) due to the presence of
numerous market imperfections and distortions it is impossible to determine whether
trade liberalization will induce net national benefits or net national losses; and D) after
trade liberalization, because of the complexity of the redistributive effects and the
inability to know if the net welfare benefits are positive, it is impossible to design a
compensation scheme to assure that everyone benefits from trade liberalization.
Thus, the only thing we can be absolutely sure of, on the basis of economic
theory, is that trade liberalization will cause some to benefit economically and others to
lose.
This result is virtually indisputable; it is difficult to imagine anyone arguing
convincingly otherwise. The inability to identify the winners and losers may not be
obvious to some observers since every economic model does identify who gains and who
loses.
However, one must remember that the real world encompasses all of these
individual model effects simultaneously. Although general equilibrium models display a
wide array of effects as they propagate through labor, capital and goods markets
domestically and internationally, these models never come close to capturing the
complexity of the real world. Each model gives us a glimpse of some of the effects, but
they do not enable us to pinpoint the detailed outcomes with any reliability.
The argument that free trade may not raise overall national welfare should also be
well known, at least in the economics profession, but here too the results comes mostly
by imagining a real world that is much more complex than any single model. In a wellspecified model it is usually possible to pinpoint precisely which policy option is best.
However, some models show free trade is best, while others show that government policy
interventions are best. Thus since the world is comprised of features displayed in all of
these models, an objective observer should recognize that in reality the effects of a free
trade policy are simply unknowable.
Finally, the inability to compensate may also not
be so obvious to many people since many economists do support compensation as a
necessary component of trade liberalization actions. The standard example is the use of
trade adjustment assistance to aid workers who lose their jobs because of a free trade
agreement. However, it should be obvious even to supporters of compensation plans, that
these actions probably do little more than quiet the most vocal adversaries of free trade
agreements and have no chance of compensating the vast numbers who lose without
knowing why.
Of course, because there will always be gains and losses from any policy change,
those who want to believe that free trade is the best policy for a nation will have plenty of
positive impacts to point to that can support that view, as long as they ignore the many
negative effects, or discount their importance in some way. Thus if someone suggests that
trade liberalization is beneficial for a country because it will generate efficiency
improvements, or if someone says that protection is harmful for a country because it will
reduce the incentive to innovate he is right. At the same time though, any individual who
wants to believe that trade protection is best for a nation can show plenty of evidence to
support that view, as long as they ignore or discount the many negative effects caused by
these policies. Thus if someone suggests that protection may be beneficial for the
country because it will save workers from losing their jobs, or if someone says that free
trade is harmful to a country because it will spoil the natural environment, theory says
that he too may be right.
Finally, what we learn from trade theory applies more generally to any
government policy. The redistributive effects described here arise solely because trade
policies change prices. Since every other tax, subsidy or regulation will affect prices as
well, every new government policy, or any removal of a policy, will cause a
redistribution of income.
The multitude of market imperfections and distortions are
affected as much by domestic policies as they are by trade policies. This means that any
government policies will cause some positive impacts, some negative, and because of the
complexity of the international economy, it will be impossible to know whether national
welfare is raised or lowered because of the policy. This also implies once again, that the
use of compensation to assure everyone benefits from any new government policy is
well-nigh impossible. This is why economic theory cannot tell us reliably what are the
best policies to choose.
There are two possible ways out of this quagmire. One method is empirical
measurement. Data collection, computational methods and computing capacity have all
expanded enormously in the past century. When theory can’t give us a definitive result,
one answer lies in measurement.
Indeed, when theory gives us several possible
outcomes, it is common for economists to proclaim: “it’s an empirical question!” The
empirical answer is offered in the next chapter. The other way out is to devise a method
of choosing policies that recognizes that positive and negative effects are the norm. In
this case we ask the question, under what circumstances is it generally acceptable to
implement a policy that will redistribute income between people. We’ll need to explore
this approach in the second part of the book because of the answer given to the empirical
question in the next section.
i
See especially Mill’s (1864) work, Utilitarianism.
ii
Most economic models assume that welfare (or utility, or happiness) is derived exclusively
from the consumption of goods and services. This is why analyses focus on changes in real
incomes; if real income rises for an individual then that person can buy more goods and services
and consequently is happier. This is what Kuenne (1993) defines as materialism. However, the
more general results that will be presented here easily apply to more complex situations in which
individuals receive utility from more than goods and services; e.g. from knowing that natural
ecosystems are being preserved, or from the safety that one feels with job security.
iii
His argument is not based on the market imperfection issue discussed in this chapter, but the
points he makes are equally valid under these circumstances. [Samuelson, Journal of Economic
Perspectives (2004)]
iv
I make a subtle distinction here. Many economic models show that free trade WILL not
maximize national welfare. In a simple model we can make definitive statements. However,
when we translate that result to the more complex real world we can only say that countries
MAY not benefit from trade.
v
Trade liberalization may increase government revenue, but only if the initial tax rate were
nearly prohibitive and if the tax reduction were not too large. In some industries in some
countries, tariff rates are nearly prohibitive, thus tariff revenue would actually rise before it
eventually falls with further liberalization.
vi
A country is “large” if its imports are sufficiently large so that a change in import volume can
influence world demand and cause a change in the world price. In contrast, for small countries,
trade liberalization would have no effect on prices in countries in the rest of the world. The US,
EU Japan and other large economies are large countries with respect to most imports.
vii
This is a general equilibrium model because it establishes equilibria (i.e., supply = demand) in
several markets (food, clothing, labor, capital) in both countries (US and Mexico)
simultaneously. This model is much more complex than the simpler partial equilibrium model
described above, but is also more comprehensive.
viii
The one exception I know of is the standard Ricardian model of comparative advantage. It
that model, with only one homogeneous factor of production – labor – all workers benefit with
trade, or are at least as well-off, in both countries.
ix
From Book 1, Chapter 1 in The Wealth of Nations:
x
The phrase “economic nirvana” was used is a similar way by Demsetz (1969).
xi
Inelastic demand means that demand does not fall very much in response to a price increase.
xii
For a modern rendition of this argument see Ha Joon Chang (2005).
xiii
See Lipsey and Lancaster (1956)
xiv
See Irwin (1996) for an historical account of the cases made for and against free trade.
xv
See Viner, Jacob (1950).